Denis Vasiliev: The Law on Controlled Foreign Companies. A Common Sense Approach

Denis Vasilev, attorney, partner at Podolsky, Vasiliev & Klein. More than 20 years of experience working with major Russian and international companies on issues of corporate structuring, taxation, real estate, as well as contract and financial law.

A lawyer’s advice to Russian subsidiaries of foreign companies, foreign managers in Russia, and Russian businesses and individuals with foreign accounts and companies.

Since the Law on Controlled Foreign Companies (CFC) took effect in January 2015, we have been following how systematically and consistently conditions are being created for its implementation in Russia.

Earlier this year, amendments were made to the Tax Code that reduced the degree of tension and reconciled the business community with the path toward deoffshorization. The procedure to calculate CFC profits was made more reasonable by eliminating the possibility of re-taxation of dividends. Business leaders were given more time to make decisions, with the deadline to file a notice of participation in a foreign company increasing from one to three months.

Another step followed in May, which was accession to an international treaty on the automatic exchange of financial information with 80 jurisdictions.

In the past, the tax authorities would issue a request to the central bank of a foreign state, which would either respond to the appeal or ignored it. With the ratification of this agreement, all financial information will be sent to the authorities automatically. By fall 2018, the tax authorities will begin receiving information about the foreign accounts of Russian tax residents – both individuals and organizations – whose beneficiaries are Russians. Russian financial institutions, in turn, will begin systematically transmitting data abroad on foreign tax residents.

In other words, our state agencies will soon have access to information on investments in securities, bank accounts and deposits, the names and addresses of their owners, account numbers and balances, the amount of interest on deposits, as well as payments on financial instruments, insurance contracts, and so on.

The tax authorities will use a global database of financial information to verify whether Russian tax residents hold shares in foreign companies, and, under certain conditions, to assess additional taxes.

Data collection is already underway in Russia. According to the Law on CFC, individuals and legal entities are obliged to inform the tax authorities of

the existence of a direct or indirect stake in a foreign entity exceeding 10%;

the establishment of a foreign structure without forming a legal entity, control over the structure or the actual right to any income earned by it;

actually controlled foreign companies (CFC).

When might you be required to pay taxes?

An order to pay taxes could arise if a person or organization is not simply a participant in a foreign company but is the controlling entity.

exceeds 10%, and Russian tax residents collectively own at least half of the business.

It is worth paying attention to one of the most powerful narratives surrounding this law – the significant expansion of the concept of tax residency. We have become accustomed to the fact that a Russian tax resident is a person who is located on Russian territory for at least 183 days a year and pays taxes here, or is a company that is registered in Russia. The Law on CFC has supplemented this definition with the term “management from Russia,” which means control of a foreign company on Russian territory.

I will offer a few examples of how this can look in practice.

Example 1. A Russian holding company hires a general director who is a foreign citizen. This CEO has a certain company he created abroad. Whether it’s a small consulting firm, a trust fund, a children’s club opened for his wife or something else altogether does not matter. According to the Law on CFC its business can be recognized as a Russian tax resident based on the fact that the owner operates it from Russia.

Example 2: A businessman living and working in Russia opens a hotel in Cyprus in a 50/50 partnership with a local hotel operator who also manages the property. Under Russian law, the businessman is recognized as a controlling entity and must report the hotel’s income and pay taxes on his profits.

Example 3: A Russian decides to buy property abroad and/or obtain citizenship in a second country. In some countries, this requires investment in the national economy. For example, it means acquiring not a house but rather shares in the company building it or in another local organization. In that case he is obliged to notify the Russian tax authorities who must then decide whether to assess additional taxes.

Who is affected by the law on deoffshorization, and what should be done about it?

The Law on CFC affects all legal entities and individuals who have a relation to foreign entities – from expat top executives with businesses in their home countries and members of the boards of directors of foreign companies (of which there are few in Russia) to the large number of Russian companies that not long ago began using completely legal offshore companies. The latter were not necessarily intending to strictly save money, but they were also seeking better protection of shareholder rights, complying with the demands of foreign partners, and acting for many other objective reasons. In fact, offshore companies were devised many years ago as a way for the English nobility to engage in trade with merchants without losing face.

For companies affected by the Law on CFC, I recommend performing an audit of existing foreign structures and describing their functions. Analyze the flow of funds. Understand what additional expenses you are facing and what you can do to minimize them. How can you restructure the flow of funds? How necessary and useful is each structure involved in it? In which of the jurisdictions would it be most advantageous to discontinue the flow? All of this is something that you will have to determine soon.

To conduct this analysis, plan and make the necessary changes that take into account all the legal requirements, you will need a team of both Russian and foreign lawyers who work with foreign jurisdictions.

The easiest way would be to ask a consulting company that belongs to an international professional association, such as the International Business Law Consortium (IBLC), to pull together a working group involving foreign partners for you.

I advise foreign companies to involve local auditors and lawyers to determine whether they are covered by the Law on CFC on the basis of control from Russia.

Main conclusions

There is no doubt that the Law on CFC will soon begin operating in full since it reflects the interests of the top officials of many states, including Russia. In my opinion, its main task is not so much the collection of taxes as the creation of a database on affiliation with foreign organizations, individuals and institutions. The information obtained can be used to make decisions on appointments to positions of responsibility, as well as admission of companies to tenders and public procurement, state secrets, and the supply of products for the needs of the military-industrial complex.

Accordingly, this path to the return of funds to the country with a “hidden agenda” is not a one-off event, but rather a strategic decision. The legal framework is being improved, and the competence of Russia’s tax authorities is increasing. In 2019, a system-wide, universal test for individuals and legal entities for evasion of CFC profit taxes will already begin. Russian tax residents will be fined for infringement in the amount of 20% of the unpaid tax (no less than RUB 100,000). This is the reality that we should begin preparing for now.